Slouching Towards Utopia?: The Economic History
of the Twentieth Century

-VIII. The Pre-World War I Gold Standard-

J. Bradford DeLongUniversity of California at Berkeley and NBER

January 1997; DRAFT 1.00

International Finance

The Pre-WWI Business Cycle

International Finance

What made the upward leap in international trade, the
creation of an integrated world economy--a world economy where for the
first time trade was not confined to luxuries and intoxicants
but extended to staples and necessities--possible in the years before World
War I? Falling costs of ocean transportation was one major factor. The
development and extension of the international political and economic order
called the gold standard was another.

The gold standard was in its origins a very simple
thing: governments and central banks all over the world declared that their
currencies were as good as gold-show up with £100 note, or a $100
bill, at the British Bank of England or the U.S. Treasury and the man behind
the counter would give you a specified, fixed, unchanging quantity
of gold: about 4.5 (troy) ounces in the case of the $100 bill, and about
22 (troy) ounces in the case of the £100 pound note.

Why did this matter? It mattered because as long as the
gold standard stood entrepreneurs could make their plans for and build
their factories engaged in international trade without having to worry
about what we today call foreign exchange risk. Consider the plight
of an American manufacturer deciding in 1980-when one British pound sterling
sells for $2.32-to compete with British producers by exporting to London;
spending the early 1980s building factories to expand capacity, and then
finding in 1985 that one pound sterling sells not for $2.32 but for
$1.30 on the foreign exchange market. The simple movement in exchange rates
since 1980 has raised the manufacturer's costs relative to those of British
competitors by 80 percent. You can bet that a very large number of productive
operations and markets that looked profitable to American businesses
in 1980 no longer looked profitable in 1985.

This is foreign exchange risk: the risk that governments
following sensible or nonsensical policies or international currency speculators
responding to their own "animal spirits" will cause exchange
rates to shift in a way that destroys a particular line of trade or bankrupts
importers and exporters. This foreign exchange risk is in large part avoided
under a gold standard. And this near-absence of foreign exchange risk was
one powerful factor driving the expansion of international trade and finance
in the years before World War I.

How did the gold standard reduce foreign exchange risk-and
close to eliminate the risk that a country would embark on a policy of
inflation that would endanger established wealth? In its idealized form,
the gold standard carried out these tasks by virtue of its working as an
automatic equilibrating mechanism.

If ever a central bank or a Treasury printed "too
many" banknotes under a gold standard, the first thing that would
happen would be that those excess bank notes would be returned to the Treasury
by individuals demanding gold in exchange. Thus each country's domestic
supply of money was linked directly to its domestic reserves of gold.

Suppose a country under the gold standard ran a trade
deficit in excess of foreigners' desired investments. It, too, would
find those who had sold goods to its citizens lining up outside the
Treasury looking to exchange banknotes for gold. And these foreign suppliers
of imports would then ship the gold back to their countries. The money
stock at home would fall as gold reserves fell. And with a falling money
stock would come falling prices, falling production, and falling demand
for imports.

So balance of payments equilibrium would be restored,
and countries' price levels kept in roughly appropriate competitive alignment,
by the gold standard as sources of disequilibrium were removed by shipments
of gold, or threatened shipments of gold, that raised and lowered nations'
reserves. Monetary authorities would find themselves restrained from
pursuing over-inflationary policies by fears of the gold drains that would
result. And since central bankers in every country were all working under
the same gold standard system, they would all find their policies
in rough harmony without explicit meetings of G-7 finance ministers
or explicit international policy coordination.

The pre-World War I gold standard was not invented. It
just grew, starting in the 1870s when Germany joined Britain, which had
defined its currency primarily in terms of gold since 1717, when Sir
Isaac Newton was Master of the Mint. Increased German demand for gold pushed
up its price; increased American mining of silver pushed down its price.
Countries that had long tried to keep both gold and silver coins legal
tender found their gold reserves falling, as people would buy cheap silver
on the world market, exchange it for currency, and then bring the currency
into the Treasury for gold. By the end of the 1870s nearly the whole world
was on the gold standard.

That exchange rates were stable under the pre-World War
I gold standard is indisputible. Devaluations were few among the industril
powers, and rare. Exchange rate risk was rarely a factor in economic decisions.

It is important to recognize that the gold standard was
a historically-specific institution. The cornerstone of the gold
standard was the commitment by all industrial-economy governments and central
banks to maintaining convertibility of their currency. The pressure that
twentieth-century--democratic--governments would feel to abandon currency
convertibility and the stable exchange rate peg in order to boot employment
or attain other economic objectives was simply absent. The credibility
of the government's commitment to the gold standard rested on the denial
of the franchise to the working class. As long as the right to vote was
still limited to middle and upper-class males, those rendered unemployed
when the central bank raised is discount rate and tightened monetary policy
had little voice in politics. As long as union movements remained relatively
weak, the flexibility of wages and prices that would allow the gold-standard
system to quickly readjust to equilibrium was present.

Later on these two preconditions for the functioning of
the gold standard would erode, and the gold standard would cease to be
a politically and economically-feasible institution.

At the periphery of the world economy, the gold standard
functioned with less success. Primary product-producing econmies were subject
to large economic shocks as the prices of their exports rose and fell.
Countries at the periphery were also subject to large shocks as British
investors' willingness to loan capital abroad went through its own less-than-rationally-based
cycles. Latin countries were repeated forced off of the gold standard and
into devaluation by financial crises.

Not only did trade expand under the gold standard, but
international capital markets expanded in the years before World War I
as well. It became a commonplace for rich people in Europe or North America
to have their money invested in far-flung enterprises on other continents.
This outflow of capital from the industrial core to the industrializing,
mineral-rich periphery was greatly assisted by the gold standard.

Later, the British economist John Maynard Keynes was to
look back on this era of free trade and free capital flows as a golden
age:

...for [the middle and upper classes] life offered, at
a low cost and with the least trouble, conveniences, comforts, and amenities
beyond the compass of the richest and most powerful monarchs of other ages.
The inhabitant of London could order by telephone, sipping his morning
tea in be, the various products of the whole earth... he could at the same
moment and by the same means adventure his wealth in the natural resources
and new enterprises of any quarter of the world, and share, without exertion
or even trouble, in their prospective fruits and advantages.... He could
secure... cheap and comfortable means of transit to any country or climate
without passport or other formality.... But, most important of all, he
regarded this state of affairs as normal, certain, and permanent, except
in the dierction of further improvement, and any deviation from it as aberrant,
scandalous, and avoidable.

Certainly free trade, free capital flows, and free migration
helped greatly enrich the world in the generations before World War I.
And certainly those economies that received inflows of capital before World
War I benefitted enormously. It is not so clear that the free flow
of capital was beneficial to those in the capital-exporting countries.
France subsidized the pre-World War I industrialization of Czarist Russia
(and the pre-World War I luxury of the court and expansion of the military)
by making investments in Russian government and railroad bonds a test of
one's French patriotism. A constant of French pre-World War I politics
was that someday there would be another war with Germany, during which
France would conquer and re-annex the provinces of Alsace and Lorraine
that Germany had annexed as part of the settlement of the Franco-Prussian
War of 1870-71. (And that France had taken from the feeble and oddly-named
Holy Roman Empire of the German Nation as part of the settlements of the
Thirty Years' War of 1618-48 and the Wars of Louis XIV of 1667-1715.) French
military strategy depended on a large, active, allied Russian army in Poland
threatening Berlin and forcing Germany to divide its armies while the French
marched to the Rhine. Hence boosting the power of the Czar by buying Russian
bonds became a test of French patriotism.

But after World War I there was no Czar ruling from Moscow.
There was Lenin ruling from Petrograd-subsequently renamed Leningrad-subsequently
returned to its original name of St. Petersburg. And Lenin had no interest
at all in repaying creditors from whom money had been borrowed by the Czar.

British investors did better from their overseas investments,
but they still did not do very well The year 1914 saw close to 40 percent
of Britain's national capital invested overseas. No other country has ever
matched Britain's high proportion of savings channeled to other countries.
Britain's overseas investments were concentrated in government debt, in
infrastructure projects like railroads, streetcars, and utilities, and
in securities guaranteed by the local governments.

However, in the forty years before World War I, British
investors in overseas assets earned low returns, ranging as low to perhaps
2% per year in inflation-adjusted pounds on loans to dominion governments.
Such returns were far below what presumably could have earned by devoting
the same resources to the expansion of domestic industry. British industry
in 1914, and British infrastructure, were not as capital intensive as American
industry and infrastructure were to become by 1929. It is difficult
to argue that Britain's savings could not have found productive uses at
home, if only British firms could have been challenged appropriately
and managed productively. And the difference in rates of return cannot
be attributed to risk: overseas investments were in the last analysis more
exposed to risk than were domestic investments.

But for capital importing countries, like the U.S., Canada,
Australia, and others like India and Argentina, the availability of large
amounts of British-financed capital to speed development of industry
and infrastructure was a godsend. It allowed for earlier construction of
railroads and other infrastructure. It allowed for the more rapid development
of industry.

Of course, the actual, real-world gold standard did not
work as smoothly as the idealizations of economic theorists. But it did
provide a stable underpinning to the growth of the world economy in the
years before World War I.

The Pre-World War I Business Cycle

However, there is a negative side to the gold standard.
The gold standard was good not only at encouraging international trade
expansion and boosting international capital flows, but also at quickly
transmitting business cycles and financial panics around the world
as fast as the telegraph wire could carry them. So borrowing foreign capital
from Britain had costs as well: it tied the borrower's economy to the financial
and employment cycles of Great Britain. "When London sneezes,"
the saying went, "Argentina [or Canada, or the U.S.] catches pneumonia."

How did this work? Look in some detail at the industrialization
of the United States to see how the typical pre-1929 depression had its
origin in the gold-standard links with the London-centered world economy.

The years between the Civil War and the 1890s saw the
great railway booms. In 1870 and 1871 U.S. railroad construction reached
its first post-Civil War peak. The number of miles of operated railroad
in the U.S., then around 50,000, grew at about twelve percent per year.
The construction of 6,000 miles of railroad track each year employed perhaps
one-tenth of America's non-farm paid labor force and half of the production
of America's metal industries.

Four years later, railroad construction had collapsed.
In 1875, railroad mileage grew at only three percent. Railroad construction
employed less than three percent of America's non-farm paid labor force,
and required perhaps fifteen percent of the production of America's
metal industries.

The depression of 1873 had its origins in British investors
loss of confidence that American railroads and infrastructure-that
day's equivalent of investments in the Pacific Rim. The largest investment
house in the United States-that of Jay Cooke, politically well-connected
industrial visionary who financed Abraham Lincoln's armies, and whose
picture hangs in the Treasury Department's antique collection in the General
Counsel's office-went bankrupt.

As a result of the collapse of Jay Cooke and Company the
City of London sneezed. The U.S. economy caught pneumonia. The share of
America's non-agricultural labor force building railroads fell from perhaps
one in ten in 1872 to perhaps one in forty by 1877-a seven percentage point
boost to non-agricultural sector unemployment from this source alone.

Such a wave-first of expanded railroad construction
as capital flowed in, and then of contraction as capital flowed out-must
have been difficult to absorb just as the Mexican recession of 1995
proved very painful. Each wave of railroad building required an expansion
of capacity in iron and steel for rails, timber for ties, equipment for
locomotives and cars, furniture to equip the cars to carry passengers on
the new lines, and most important the redirection of one million workers
to railroad construction. As the wave passed, suppliers and workers would
have to find new markets and new jobs. The dislocation generated may
well have been extreme and severe. But we know little about how it was
accomplished, or about what workers who built railroads in 1871 were doing
in 1875.

It is hard to attribute such spasms of construction to
independent disturbances in finance: railroad finance was
then more-or-less the sole business of Wall Street. By default such depressions
appear to have been driven by waves of optimism about future growth, followed
by recognition of overbuilding and contraction until the economy had grown
enough that it seemed that shipping by rail was a railroad's and not a
farmer's market.

The gold standard appears also in the depression of the
1890's. The possibility that "free silver" might sweep American
politics made investors and financiers uneasy. Relative to what they
would earn if they kept their cash, investments, and capital in London,
a free-silver victory and subsequent devaluation might well have cost them
a third of their wealth as measured by the international yardstick of the
gold standard. Perhaps the free-silver movement was powerful enough to
cause capital flight, investment shortfall, and depression, but not strong
enough to secure devaluation and monetary expansion to reduce the debt
burdens of farmers and create a booming labor market for urban workers.
The U.S. thus got the worst of both worlds: it suffered the disadvantages
of being on the gold standard without reaping the gold standard advantage
of keeping financiers confident and investing. Moreover, the
panic of 1907 followed a recession in Great Britain. As a result of the
recession, the Bank of England raised interest rates to pull gold to London
to boost its reserves. This left the United States short of currency to
be paid out to farmers and middlemen during the fall shipment of the harvest
to the East. Financial panic followed, and recession followed the financial
panic.

It is very clear that depressions before 1929 were more
painful than depressions today. Those who lost their jobs had no welfare
state to cushion them. Individual states had sketches of a future welfare
system, but such embryonic systems did not have the resources to cope with
episodes of widespread unemployment. Extended families, friends, and local
benevolent associations must have provided support for those who lost their
jobs to remain, for the most part, fed and housed. American cities during
depressions at the turn of the century were centers of poverty and want,
but apparently not of mass near-starvation.